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ISLAMIC ECONOMICS & FINANCE -TRISAKTI

Sukuk as Instrumentand Investment

in Islamic Capital Market

by: Saebani HardjonoAssignment of Dr. Abul Hassan - A Class of Islamic Capital Market

Post Graduate Program IEF TRISAKTI - Jakarta - Indonesia

SAEBANI HARDJONO - 22208120619th August 2009


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Saebani Hardjono - Post Grad. Program IEF TRISAKTI - JKT Sukuk as Instrument and

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SAEBANI HARDJONO -

222081206


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Sukuk as Instrument and Investment

in Islamic Capital MarketBy: Saebani Hardjono - 222081206

Assignment of Dr. Abul Hassan for: A Class of Islamic Capital Market

Post Graduate Program - IEF TRISAKTI Jakarta, Indonesia19th August 2009

Introduction

Sukuk, as Islamic fixed-income instruments investment are already emerging and there are strongdemand as significant as class of asset investment, and as potentially important for the Musliminvestor as conventional bonds [IMF Study (2007), Euromoney (2007 & 2008), Arthur D. Little(2009), Standard & Poors (Q1 2009), Ernst & Youngs (2009), HSBC Asset Management (2009)]. Inaddition, for non-Muslims who already own conventional bonds, the acquisition of sukuk introduces anew instrument into their portfolios investment as asset class, bringing further welcome diversity and

possibly reducing risk.

As we understand that the prohibition of interest (riba) in Islamic investment is invoked to createmarket demand for an Islamic alternative (Mahmoud El-Gamal, 2007), that Muslim can rely on incomplying with Shari'a-based rules in the Islamic investment in Sukuks capital market, throughfinancial engineering. Which is established with underlying ofShari'a-based rules and issues thatdrive a unique investing discipline.

However, the market for Sukuk--Shari'a compliant investment and finance-- is truly an emergingsubsegment of the broader emerging markets. As a result, the area of fixed income simultaneously israpidly growing and not well understood in the Islamic capital markets and their global financial

partners.

Nonetheless, the use of Sukuk to fulfill the demand for fixed-income instruments is broadening theIslamic marketplace as well as bringing new diverse instruments to the global capital markets.Arguably the most recent innovation in financial instrument, Sukuk, notwithstanding its religiousroots, is not unlike any other financial instrument that it is product that is created by market demand(International Financial Law Review, Mar 2009).

Objective

Sukuk or Islamic bonds is now in the capital market becoming popular among form ofIslamic finance as asset based capital market. The objective of this paper is to enhance

the general understanding of Sukuk as an instrument and investment in the capital market.

Methodology

The research methodology implemented in this study is a literatures study, in the area ofIslamic financial of Sukuk in the global market.

Background

Rodney Wilson ( 2004) says that modern Sukuk, sometimes referred to as Islamic bonds, are betterdescribed as Islamic investment certificates. This distinction is as crucial as it is important, and it is

stressed throughout this pioneering work that Sukuk should not simply be regarded as a substitute forconventional interest-based securities. The aim is not simply to engineer financial products that mimic


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fixed-rate bills and bonds and floating-rate notes as understood in the West, but rather to developinnovative types of assets that comply with Sharia Islamic law.

The Shari'a'salternative approach

to financial governance in Sukuk investment

Often, the views presented among western lawyers, regulators and journalists is that the Shari'a isalien in its aims and methods. This position is based on a lack of interaction with their peers who aretrained in Shari'a and ignores the reality that every society has very similar needs to organise whetherin the areas of criminal law, property rights or financial relationships.

The Shari'a, however, is a highly structured rules system. It may be law in some countries, a parallellaw in others or ethical guidelines applied by individuals in yet others. The primary basis for the rulesis the Qur'an, or the holy text of Islam. This text is not meant as a law book; rather it contains a deeparray of knowledge required by a Muslim.

Indeed, the Qur'an has a large number of legal dictated and indicates the direction for formulating

law, but provides moral and spiritual guidance. Therefore, Muslims turn to a second source of law, thehadith, or verified sayings and observations of the Prophet Muhammad's (peace be upon him)

behaviour. In the hadith, a substantial number of legal and moral maxims are defined. These govern agreat number of life situations and provide a basis to draw conclusions relating to modern situations.Often referred to as 'Qur'an and Sunnah', these are the bedrock of the Shari'a. Islam spread rapidly inthe Mediterranean, Indian Ocean and Central Asian regions. This meant a great deal of contact withnew cultures and new ways of organising matters, both financial and social.

The position of the early Muslim rulers and their jurists was not to cast out every new idea, but toexamine the adat, habits, and uruf, customs, of a people. When it was the consensus or ijm'a of the

jurists that these behaviours did not contravene any of the primary values of Islam, they were not

forbidden. When an unobjectionable behaviour was unrelated to anything reported in the Qur'an,hadith orathar, but instead dealt with something deemed unique, the adatand urufwere allowed toinform the application of the Shari'a. The application of adat and uruf is fundamental to theexpansion of Islamic investing and the trading of Islamic securities on a global basis.

For instance, the custom in most Islamic cultures is to place the burden of paying property taxes andindemnities or insurance on the primary owner of a property, even if the owner anticipates that his/her

partner or tenant will buy out the property subject to some term or condition in their lease orpartnership documents. Muslim jurists, however, anticipate that the primary owner will recover thesecosts in the rent or partnership-sharing arrangements.

What this means in practice will hopefully become apparent to readers of this paper, but it is worth

stressing here that the essential concepts are:

Transparency and clarity of rights and obligations;

That income from securities must be related to the purpose for which the funding is used,

and not simply comprise interest; and

That securities should be backed by real underlying assets, rather than being simply paper

derivatives.

Sukuk as Islamic fixed-income securities are already emerging as a significant instrument as class ofasset investment, and are as potentially important for the Muslim investor as conventional bonds forinvestors generally. In addition, for non-Muslims who already own conventional bonds, the

acquisition of sukuk introduces instrument in investment a new asset class into their portfolios,bringing further welcome diversity and possibly reducing risk.


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The contents and structure of Sukuk

There are several different methods of investment in real asset based on the principles of Shariahlaw, Ijara, Murabaha, Musharakah and Murabahah. However, all such finance structure have to be

certified by a panel of experts, a Shariah board. In addition, each transaction will have to bescrutinised by a Shariah board to ensure full compliance with Islamic principles (RREF Real EstateResearch, 2008).

Indispensable guide to the options available for those seeking to raise finance through Sukuk issues orinvest in Sukuk securities. Professional bankers and finance specialists can learn how to structureSukuk, and how such securities can be used as tools for asset and liability management. Muchattention and space is justifiably given to sovereign Sukuk as issues by Malaysia, Bahrain and Qatarhave attracted widespread international attention from both Islamic and conventional bankers. Thescope for converting existing conventional government debt into instruments enjoying Shariaacceptability is clearly enormous, as is the possibility of issuing new debt on potentially cheaper andless risky terms than those applying to conventional bonds.

Although, so far, there have been relatively few corporate Sukuk, such Islamic securities couldbecome a vital financing tool for companies throughout the Muslim world as well as in the West. Thescope for refinancing housing and commercial Sharia-compliant mortgages have been structuredthrough Sukuk . As Sukuk have to be asset-backed, housing and real estate represent an especiallyfertile field for such Islamic security issues. Those contemplating launching Sukuk or investing insuch instruments will naturally be concerned with legal and taxation matters. There is a problem thatneeds to be solved, it is Enabling infrastructure, which addresses the issue of whether some

jurisdictions are better than others for Sukuk issues, as well as how the income from Sukuk is treated,or may be potentially treated, for taxation purposes.

The following caption is an illustration of the Sukuk finance structure, that is Sukuk al-Ijarah.

An Illustration of Sukuk Finance Structure


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The legitimacy of Sukuk

Although there is no compulsion to comply with the rulings of the Fiqh Academy of the Organizationof the Islamic Conference, their rulings carry considerable weight with most Islamic financial

institutions and their Sharia committees and advisers. At the request of delegates from Jordan,Pakistan and Malaysia, the Fiqh Academy considered the question of Islamic investment certificatesat their fourth annual plenary session held in Jeddah in February 1988. They noted that the Shariaencourages the documentation of contracts as stipulated in sura 2:282 of the Holy Quran:

When ye deal with each other, in transactions involving future obligations in a fixed period oftime, reduce them to writing. It is more just in the sight of God, more suitable as evidenceand more convenient to prevent doubts among yourselves.

Why have Islamic bonds or Sukuk in the capital market?

Rodney Wilson explains that conventional bonds that yield interest, or riba, are of course prohibited

under Sharia law. Furthermore, those who buy and sell conventional bonds are rarely interested inwhat is actually being financed through the bond issue, which could include activities and industriesthat are deemed haram such as the production or sale of alcohol. Companies that are highly leveragedwith bank debt may seek refinancing through issuing bonds, but such companies are not regarded assuitable for Muslim investors.

The aim of bond traders in the capital market usually is to make capital gains as fixed-interest bondprices rise when variable market interest rates fall. Bond trading is there for largely about exploitinginterest rate developments and trading in paper that is usually unrelated to the value of any underlyingasset.

The major risk for holders of conventional bonds is of payments default, but this risk is usuallyassessed solely on the basis of credit ratings, with the ratings agency rather than the bond purchaserestimating the risk. Hence the bonds are regarded as mere pieces of paper with third parties estimatingthe risk and the purchaser, at best, only making a risk/return calculation without any reference to the

business being financed.

A number of Sharia scholars, most notably Muhammad Taqi Usmani, have stressed that one of thedistinguishing features legitimising Islamic finance is that it must involve the funding of trade in, orthe production of, real assets (Islamic Bonds by Nathif J. Adam, 2004). Merely funding the purchaseof financial securities would involve second order financing akin to lending for derivatives, thesubsequent gearing being speculative and increasing uncertainty, orgharar.

Hence, with murabaha, commodities are purchased on behalf of a client and resold to the client, thetemporary ownership of the commodity justifying the financiers mark-up. Istisnaa involves thefinancing of manufacturing capacity through pre-production payments, but these relate to constructionor equipment purchases where real capacity can be identified. Similarly, ijarah involves the leasing ofreal assets, with the use of the assets justifying the payment of rental to the owner.

As Islamic finance is by nature participatory, purchasers of Sukuk securities arguably have the right toinformation on the purposes for which their monies are to be allocated. In other words, the fundingraised through Islamic bond issues should be hypothecated or earmarked rather than used for generalunspecified purposes, whether by a sovereign or corporate issuer. This implies that identifiable assetsshould back Islamic bonds or Sukuk(Rodney Wilson, 2004).

Shariah-Compliant of Islamic Bonds or Sukuk Investment


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Shariah-compliant investment represents a series of ethical financial transactions that are organised inaccordance with Islamic law. The range of investment opportunities complying with Muslim religious

beliefs has historically been fairly limited. In order to offer new investment vehicles for thoseinvestors who are looking to develop a self-invested personal pension, or a small self-administeredscheme, a new system of Shariah-compliant investment funds has emerged. These funds do not permittransactions that are eschewed by Islam, including option trading or interest-based transactions, suchas margin trading and short selling.

Sukuk are issued based on the Shariah ruling that having fundamental underlying to the Quran and theSunnah of the Prophet Muhammad, and it governs all aspects of personal and collective life. AsIslamic investments instrument Sukuk must be carried out in accordance with the fundamental

principles of Islamic law.

A Shariah board of Islamic scholars advises the financial institution in the development of Shariah-compliant products. The most distinctive element of Islamic investments instrument is the

prohibition of interest, whether "nominal" or "excessive," simple or compound, fixed or floating.Other elements include the emphasis on equitable contracts, the linking of finance to asset and

productivity, the desirability of profit sharing, and the prohibition of gambling and certain types ofuncertainty.

These parameters define the nature and scope of Islamic bonds or Sukuk, as interpreted by the Shariahscholars that work with financial institutions.

Saving and investing in line with religious principles is important for many Muslims, and anincreasing range of financial products are now available to meet Shariah rules. Islam is very clear on anumber of financial topics. While trade and investment are encouraged, Shariah rules prohibitinvolvement in alcohol, gambling, pornography, abortion, human cloning, defence, conventional

banks or insurers, and most forms of entertainment. Industries associated with pork are prohibited.

Sukuk issuance have to conform with the most fundamental aspect of Shariah compliance is theprohibition of any form of usury, or riba. Any amount in a contract of loan or debt regardless ofsize--that exceeds the principal is riba. Such contracts are prohibited by the Quran, regardless ofwhether the loan is taken for the purpose of consumption or for some production activity. Thisindicates that any forms of receiving or paying interest are not allowed, because Islam defines allforms of interest as usury. The rationale behind the prohibition of interest in Islam suggests aneconomic system where all forms of exploitation are eliminated. In particular, Islam wishes toestablish justice between the financier and the entrepreneur.

The financier should not be assured of a positive return without doing any work or sharing in the risk,while the entrepreneur, in spite of his management and hard work, is not assured of such a positivereturn. In general, there are two forms of forbidden riba:

1. Riba al-fadl, where a particular good is exchanged for another hand-to-hand, but indifferent quantities; and

2. Riba al-nasiah, where money is exchanged for money with deferment.

Key Principles of Shariah Finance for Sukuk Issuance

RREEF Research (Jun 2008) identifies the key principles of Shariah relevant to finance transactionsthat must be beared in Sukuk include the prohibition as follows :

1. Interest (riba): Shariah regards money as simply a means of exchange, without intrinsic valueand holds that money cannot be used to make money. Interest is the classic example of riba.


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Payment or receipt of interest is strictly prohibited, and any obligation to pay interest isconsidered void under Shariah.

2. Speculation (maisir): Shariah prohibits and treats as void transactions that rely on chance orspeculation, rather than efort, to produce a return. This can create problems in relation tocontracts that are seen as tantamount to gambling, which includes some conventionalderivative transactions such as swaps, futures, and options.

3. Uncertainty (gharar): Shariah prohibits and treats as void contracts that are uncertain. All thefundamental terms of a contract (such as subject matter, price, and time of delivery) must beabsolutely certain at the outset.

4. Unjust enrichment/unfair exploitation: Shariah prohibits and treats as void contracts underwhich one party unfairly exploits the other or gains unjustly at their expense.

5. Unethical purpose: Shariah-compliant finance can be raised only for purposes that arepermitted by Shariah and for the benefit of society.

Sukuk as Shariah-Compliant Alternative Investments Instrument

The capital available for deployment into Shariah-compliant investments is vast and growing. At theheart of the Middle East, the countries of the Gulf Cooperation Council Saudi Arabia, Kuwait, theUAE, Bahrain, Qatar, and Oman form a market of 38 million residents with a combined annualGDP growth rate that currently exceeds the booming Asia Pacific region. Add to this another 430million Muslims living outside the Middle East, and the market suddenly appears quite large.

Strong economic growth, rising oil revenues, and healthy current account surpluses in many Muslimcountries are among the factors supporting the growing potential of Shariah-compliant investment.

Muslim investors have different allocations and appetites for Shariah-compliant products. Institutionalinvestors from the Middle East may allocate up to 25% of their portfolios to Shariah-compliantoptions, while high net worth individuals in GCC countries allocate as much as 75%. Other investorallocations may fall somewhere in between.With these allocations, the market potential for Shariah-compliant products could feasibly exceedUS$1 trillion.

Traditional assets, such as equities and fixed income, remain the main asset classes for investors in theGCC region, while mutual fund investing in these countries is growing at an average annual rate of23%. Cross-border investment into Europe and the US has often tended toward alternatives,especially real estate.

Real estate and infrastructure investments provide a series of attractive characteristics including stableand regular income, and good diversification. Given these intrinsic characteristics, many Islamicinvestors have found real estate investment an attractive option when investing overseas. Significantopportunities currently arise for Shariah-complaint products, but the challenge will be packaging realestate and other investment opportunities into acceptable Shariah compliant transactions and financialinstruments. Several reasons support this case:

Strong economic growth in the Middle Eastsupports greater affluence and increasing

demand for Shariah-compliant products.

Low penetration levels by Islamic fundsand lack of depth across asset classes and

products signifies untapped potential.


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Movement away from conservative portfoliosparallels an emerging interest in

alternative investment options.

Recent and forthcoming regulatory reformsmay prove beneficial for growth in the

market.

GCC government surpluses are oriented toward investments in infrastructureprojects

to stimulate long-term economic growth. Among these opportunities, however, specific

challenges must be recognized.

The challenges are:

A lack of common standards of Shariah principles;

Limited expertise in Shariah law to support required boards; and

Limited options for structuring financial instruments.

Given the strong underlying demand for Shariah-compliant products, further development on standardcertification on Sukuk will be a high priority. While the range of investment opportunities complyingwith Muslim religious beliefs has historically been fairly limited, the emergence of Shariah-compliantinvestment offers a major market opportunity that has yet to be fully developed. The table below willgive us a picture of how Islamic countries during 2002-2007 are pursuing to penetrate the globalSukuk market.

Selected Issues Sukuk

Sovereign & Corporate Issuer

Islamic Countriess GDP and HNW as Capital Source

Demand for Islamic products has spread across the world, and well beyond the Middle East. There aremore than 430 million Muslims outside the traditional Middle East (a region that stretches from the


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Mediterranean to Pakistan), including 190 million in Indonesia, 73 million in Turkey, 150 million inIndia, 20 million in Europe, 7 million in the US, and 17 million in North Africa. It is reasonable toassume that many of these 430 non-Middle Eastern Muslims could be interested in Shariah-compliant

products include Sukuk. In India, for instance, the government has recommended the establishment ofa framework for Shariah compliant mutual funds in order to provide investment options for theMuslim community (Deutche Bank, 2007).

Despite the increasing interest across the world, the GCC countries still represent the most apparentand immediate opportunities for Shariah-compliant products. Although the GDP of Pakistan and Indiais far higher than the GCC, the wealth of the GCC is greater, as is the demand for Islamic savings

products (Table below). The GCC countries account for 45% of the global Islamic High Net WorthIndividuals (HNWIs), or about US$700 billion.

Given the wealth of the region and the demand for Islamic products the following section focuses onthe sources and scale of capital for the GCC region only.

Islamic Countries GDP and HNW (High Net Worth) Wealth

The number of Islamic financial institutions worldwide has grown rapidly to over 300 withcapitalisation in excess of US$13 billion, including banks, mutual funds, mortgage companies, andTakaful or mutual insurance.

According to Kuwait Finance Houses 2008 estimates, more than 50% of financial services in theGCC block will be Shariah-compliant by 2020. Given the fast-growing wealth and population of theIslamic world there is a clear need to provide products that are suitable for their needs (Forcast fromGlobal Insight, 2008).


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Over recent years, there has been a surge in demand for Shariah investment products. Given thegrowing wealth of the region, this global flow to Islamic ethical funds is set to continue in the nextfew years, with McKinsey estimating that it will grow at 25% p.a. until at least 2011, a rate of growththat is 50% higher than non-Islamic products (McKinsey, 2006).

Although fast-growing Shariah-compliant asset management products (a subset of Islamic finance)remains relatively small, with McKinsey estimating it to represent 6% or $US150-180 billion of GCCinvestable assets. Before exploring the scale of the market, it is worth of identifying the drivers of theIslamic financial market.

Factors Driving the Growth of Islamic Finance including Sukuk

1. Strong Economic Growth

The GCC region is a small but important part of the global economy. Its 2007 real GDP wasaround US$810 billion, accounting for just 2.1% of the global total (Global Insight, Q4,2007).

Despite the relatively small size of their economies and populations, the rate of GDP growthin GCC countries reached 6.4% in 2007, which is similar to the Asia Pacific average (5% to6%). Its growth rate exceeded the averages for Latin America, Europe, the OECD and theMiddle East.

In terms of GDP per capita, Qatar, the UAE, and Kuwait rank among the highest in the world,and well above the Euro Zones average (as seen at the Table below).

Forcast The Real GDP Growth (%), 2003 2037

2. Rising Oil Revenue

The GCC region holds around half of the worlds known oil reserves. Oil earnings accountfor 70% of the GCCs exports and revenues.


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According to Global Insights, the GCC economies are estimated to post a record budgetsurplus of US$188 billion for 2008, from less than US$10 billion in the beginning of thedecade.

The revenue from exports has also increased from US$280 billion in 2004 to US$510 billionin 2007, a 77% increase over the three-year period (Global Insights, 2008-Q1 forcastingdata-as Table below).

Total GCC Export Revenue Trend (US$ Billions)

3. Healthly Current Account Surplus.

Increasing oil prices have driven up returns on hydrocarbon exports to create a currentaccount surplus. Free trade agreements are currently being discussed with the EU, Japan, andIndia. Potentially, these agreements could diversify export destinations. At this moment, theAsia Pacific region is the main export destinations for the GCC countries.With the continuing inflow of FDI into the energy and construction sectors, the GCC has

become more open to foreign capital. The current account surplus is expected to remainrelatively high by world standards (as seen at The Graph below). The introduction of a CommonMarket (CM) in January 2008 will also provide new opportunities and deepen economic ties.

Current Account Balance as a Share of GDP (%)

GCC Countries, 2004 2037


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Sukuk or Islamic bonds

Demand for sukuk has been strong in recent years. The boom in oil prices has delivered acash windfall for Middle Eastern investors at a time when they are becoming moremeticulous in applying religious principles to their investments. Since its birth in 2002, thesukuk market has grown remarkably. Standard & Poor's recently estimated that the globalmarket is worth over $80 billion ( Euromoney Institutional Investor PLC Dec 2007).

The Sukuk market is expected to continue to grow, as more businesses seek to tap the liquidpetrodollars and the demand for shariah -compliant products. From an investor's perspective,Sukuk are emerging as a notable asset class. In addition, non-Muslims who already ownconventional bonds may see the acquisition of sukuk as introducing a new asset class intotheir investment strategy, one that brings diversity to their portfolio. In the past, most Sukukissues have been oversubscribed, showing the high demand from investors. But even thoughthe market is developing rapidly, it faces several impediments. Most of these are interlinked,and timely initiatives would overcome them. In mid-April 2009 the Indonesian Governmentcompiled the first international Sukuk for $650 million and generated $4.6 billion of demand

testament to the enormous potential of the market (Global Finance, 2009).

In the past, Islamic financial services handled relatively small transactions with individualconsumers, but since the beginning of the century they have expanded rapidly due to theissuing of Sukuk bonds, Sukuk permit the raising of large amounts of capital, and Sukuktransactions markets have been developed to promote the dispersion of investment risk.Islamic finance has expanded tremendously as a result.The graphs as follow respectivelygivingan information such as: Graph 1: Global Sukuk Issuance (2001-2008), Graph 2: Global Sukuk

Issuance by Country (2008), and Graph 3: The Total amount Sukuk Issuance in US$ denominationand other currencies (2005-2008).

Graph 1: Global Sukuk Issuance (2001-2008)


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Source: Standard&Poors: Islamic Finance Outlook 2009

Graph 2: Global Sukuk Issuance By Country in 2008

Source: Standard&Poors: Islamic Finance Outlook 2009

Graph 3:Total Sukuk Issuance (2005-2008)


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Source Standard&Poors: Islamic Finance Outlook 2009

There are two famous types financial structure for Sukuk, namelyMusharakahand Ijara.

Typical financial structure for sukuk (I) Musyarakah

Musharakah: Equity participation where profits and losses are shared. Under theMusharakah form of money management, capital is procured by issuing sukuk and then used

for an investment project specified beforehand by the issuer.

If the project yields a profit, it is distributed among the investor partners at pre-agreed ratios.If the project yields a loss, it is born by the investors in proportion to their capitalcontributions.

Typical financial structure for sukuk (II) Ijara


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Ijara: Lease-and-sell method

A Special Purpose Company (SPC) is established for the purpose of raising funds. The

fundraiser sells material assets to the SPC (for example, a building held by a financial

institution), then establishes a new leasing arrangement with the SPC.

The SPC issues sukuk backed up by this transaction, thereby raising capital. The SPCpurchases and holds the leased assets, and allocates leasing income in the form of dividends

(corresponding coupons) to the investor.

The fundraiser allocates capital procured through the SPC to finance the project.

When the sukuk are redeemed, the fundraiser has the option of buying back the assets from

the SPC, with the SPC allocating the money received from this sale to the investors.

Enlarge this image

Types of investment in Sukuk

There are several types of investment Sukuk including the following :

1. Certificates of ownership in leased assets

These are certificates that carry equal value and are issued either by the owner of a leasedasset or an asset to be leased by promise, or by his financial agent, the aim of which is to sellthe asset and recover its value from subscription, in which case the holders of the certificates

become owners of the assets.

2. Certificates of ownership of usufructsThese certificates have various types, including the following:

2.1. Certificates of ownership of usufructs of existing assets

These are documents of equal value that are issued either by the owner of usufruct ofan existing asset or a financial intermediary acting on the owners behalf, with theaim of leasing or subleasing this asset and receive rental from the revenue ofsubscription. In this case, the holders of the certificates become owners of theusufruct of the asset.

2.2. Certificates of ownership of usufructs to be made available in

the future as per description


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These are documents of equal value issued for the sake of leasing assets that thelessor is liable to provide in the future whereby the rental is recovered from thesubscription income, in which case the holders of the certificates become owners ofthe usufruct of these future assets.

2.3. Certificates of ownership of services of a specified supplier

These are documents of equal value issued for the sake of providing or sellingservices through a specified supplier (such as educational programmes in a nominateduniversity) and obtaining the value in the form of subscription income, in which casethe holders of the certificates become owners of the services.

2.4. Certificates of ownership of services to be made available in the

future as per description

These are documents of equal value issued for the sake of providing or sellingservices through non-existing supplier with the description of the subject matter (suchas educational programmes of a specific quality, schedule, duration, etc. withoutmentioning the educational institution) and obtaining the value in the form of

subscription income, in which case the holders of the certificates become owners ofthe services.

3. Salam certificates

These are documents of equal value issued for the sake of mobilising Salam capital and theitems to be delivered on Salam basis are owned by the certificate holders.

4. Istisnaa certificates

These are documents that carry equal value and are issued with the aim of mobilising thefunds required for producing a certain item and the items to be produced on Istisnaa basis areowned by the certificate holders.

5. Murabaha certificatesThese are documents of equal value issued for the purpose of financing the Murabahacommodity and the certificate holders become the owners of the Murabaha commodity.

6. Participation certificates

These are documents of equal value issued with the aim of using the mobilised funds forestablishing a new project or developing an existing one or financing a business activity onthe basis of one of partnership contracts. The certificate holders become the owners of the

project or the assets of the activity as per their respective shares. The participation certificatesmay be managed on the basis of Musharaka or Mudharaba or through an investment agent.

6.1. Participation certificates managed on the basis of Musharaka

contractThese are documents representing projects or activities that are managed on the basisof Musharaka by appointing either one of the parties or any other party to manage theoperation.

6.2. Participation certificates managed on the basis of Mudharabacontract

These are documents that represent projects or activities that are managed on thebasis of Mudaraba by appointing mudarib for management.

6.3. Participation certificates managed on the basis of investment agency


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These are documents that represent projects or activities that are managed on thebasis of investment agency by appointing an agent to manage the operation on behalfof the certificate holders.

7. Muzaraa (share cropping) certificatesThese are documents of equal value issued for the sake of using the mobilised funds infinancing a Muzaraa contract. The certificate holders become entitled to a share in the cropas per agreement.

8. Musaqa (irrigation) certificates

These are documents of equal value issued on the basis of a Musaqa contract for the sake ofusing the mobilised funds for irrigating trees that produce fruits and meeting other expensesrelating to maintenance of the trees. The certificate holders become entitled to a share in thecrop as per agreement.

9. Mugarasa (agricultural) certificates

These are documents of equal value issued on the basis of a Mugarasa contract for the sake of

using the mobilised funds for planting trees and meeting expenses of the work. The certificateholders become entitled to a share in the land and the lantation.

10. Concession certificates

These are documents of equal value that are issued for the sake of using the mobilised fundsto finance execution of a concession offer in which case the certificate holders becomeentitled to rights associated with the concession.

Sukuk transactions, including non recourse financing, appear to be gaining tractioning the Gulf regionfor project and infrastructure funding as investors become familiar with their features and flexibility.While the global economic slow down may have curtailed the uptake of these transactions for now,investor appetite should recover in line with the business cycle. At the same time, however, the

continued success of project and infrastructure Sukuk will in Standard & Poors Ratings Servicesopinion require the resolution of outstanding compliance and security related issues.

These transactions notwithstanding, project and infrastructure Sukuk issuance in the Gulf has stalled.After years of rapid growth, the past few quarters have been difficult in the Gulf Cooperation Council(GCC) states and the project and infrastructure Sukuk markets have not grown in 2008 to the levelsanticipated.Global Slowdown And Local Factors Crimp Sukuk Issuance

The markets anticipated growth of sukuk (including those for infrastructure and project finance)failed to materialize in 2008, total sukuk issuance falling 56% to $14.9 billion compared with the

previous year. That said, the value of Standard and Poor's rated project and infrastructure sukuk was

broadly similar in both 2007 and 2008. We believe that the underperformance in sukuk issuance isdue in large part to the effects of the global economic downturn, specifically its influence on capitalmarket issuance in GCC states. We are of the view, however, that notwithstanding the current state ofthe financial markets, the GCC will be the focus of most infrastructure and project finance Sukukactivity in the short to medium term. This is because Sukuk funding structures provide an alternativeto the traditional bank financing that shows no immediate signs of return in the currently dislocatedfinancial markets.

Muneer Khan, (2009) Dubai-based partner with the Simmons & Simmons law firm, in The WallStreet Jounal says, there was a double whamy for the Sukuk market. Even as the Global financialcrisis and falling oil prices took a severe toll, investors had to digest the implications of a back to

basics movement among some scholars in Shariah law.


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In 2007, respected Pakistani scholar Muhammad Taqi Usmani delivered a bombshell, suggesting thatthe most popular type of Sukuk structures, responsible for up to 85 % of issues, were unlawfullaccording to Islam (Stephen Fidler, Wall Street Journal Jun 2009). Allthough, Damak says the Sukukmarket has potential to rebound once such issues are resolved. He estimates there are more than $50

billion of Sukuk in the pipeline awaiting the right market opportunity (Wall Street Journal, Jun 2009).

Local factors curb investor appetite for sukuk

The effects of the global downturn aside, the GCC region has its own contributing macroeconomicfactors that continue to affect project and infrastructure Sukuk issuance, namely: High costs of

financing. The costs of structuring and issuing Sukuk remain high relative to conventional bank loansand bond issuance. Legal and accounting fees contribute to this higher cost structure, as doesuncertainty regarding the perceived risk associated with.

These instruments, moreover, the lack of standard structures, perceived differences in approach tosharia compliance, and a relatively illiquid secondary market may, in our view, discourage investorappetite for sukuk.

In 2006 and 2007, there were a number of sukuk placed with international investors, including thoseof DP World Ltd. (A/Negative/A-1) and Tabreed. In 2008, by contrast, the reduced appetite for Sukuksaw many issues taken up by local investors and denominated in local currencies. Furthermore,foreign currency-denominated, cross-border-placed Sukuk remain more expensive than their locally

placed counterparts. This is due to withholding tax payments applicable to cross-border transactions,on which investors demand a compensating coupon. Finally, that uncertainty over the prevalent

practice of pegging GCC state currencies to the U.S. dollar may also make foreign-currencydenominated Sukuk less attractive than those issued locally. As a consequence, local currency Sukukhave been dominant. The relative degree of liquidity tightening in these local markets compared withlevels a year earlier also contributed to funding costs.

Real estate downturn.The correction in UAE real estate markets, particularly in Dubai in the second half of 2008, suggeststhat government-related developers, utilities, and infrastructure companies reliant on third-partyconstruction might be revising their financial and business models to reflect new marketcircumstances. This, in turn, suggests that funding of discretionary capital expenditures in the secondhalf of 2008 through Sukuk issues is likely to have been indirectly affected.

Hydrocarbon prices.

The reduction in oil prices from around $128 per barrel at the end of June 2008 to around $40 perbarrel at the end of December has, in our view, dampened wealth expectations in the GCC. This, in

turn, has likely affected expansion plans for government entities by placing more scrutiny on theprojects that should progress. Cheaper oil prices may have also affected local issuer and investorappetite for infrastructure and project finance sukuk.

Accounting issues.

In our view, the February 2008 announcement by the Accounting and Auditing Organization forIslamic Financial Institutions (AAOFI), which addressed the issue of whether bonds structured withno transfer of collateral were sharia-compliant, contributed to market uncertainty. We understandanecdotally that the AAOFI's position may have prompted investors to seek a risk premium for

particular Sukuk transactions and, consequently, to a lull in issuance. We are not aware of anysubsequent action taken by the AAOFI.

Despite these developments, high-profile Sukuk issuance continues in the region. Both the SaudiElectricity Co. and Dubai Electricity and Water Authority issued Sukuk in late 2007 and during 2008


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to fund capital expansion in Saudi Arabia and Dubai, respectively. Sukuk-based financing remains themost attractive means of raising funding for medium and long-term capital costs for GCC issuers. Itforms the basis of a number of high-profile, hydrocarbon-related GCC project transactions, often splitequally with debt-based bond and bank financing. As the Islamic infrastructure and project financemarket develops, we anticipate there will be more transactions funded exclusively by sharia-complaint means.

The Sukuk Instrument Proves Adaptable

In our opinion, Sukuk have proven adaptable to complex infrastructure financing, as evidenced inthe Tabreed 08 and Sun Finance projects. Its our understanding that one of the purposes of theTabreed 08 sukuk, for instance, was to raise financing for Tabreeds capital facilities expansionwithout increasing leverage. Tabreed 08 issued non deferrable, deeply subordinated, and mandatoryconvertible ijara Sukuk notes. In practice, annual profits are distributed to Tabreed 08, which servicesthe notes over three years prior to conversion. Principal and interest payments are subordinated to allof the parent companys other debt obligations (unless expressly qualified as more junior) and rankedat the time of issuance senior only to common shares. Although the Tabreed 08 notes have sufficient

debt-like characteristics to enable them to be rated, Standard & Poors treats the principal amount ofthe notes as equity in order to calculate Tabreeds financial ratios. Similarly, we treat coupon

payments as dividends for the purpose of our analysis. Since the Tabreed 08 issue, we have also ratedconvertible notes issued by Abu Dhabi National Energy Company PJSC (TAQA; AA-/Stable/A-1+).

However, these were not structured as Islamic convertible notes. We believe that once conditionsimprove in the financial markets, infrastructure developers seeking high equity treatment for capitalmarket issuance may continue to employ sharia-compliant convertible notes to fund their capitalneeds. As we discuss below, Sun Finance, a construction financing backed by property receivables,has in our opinion already helped to extend the boundaries of nonrecourse project and infrastructureSukuk financings.

Andreas Jobst, and Peter Kunzel, cs., (2008), in the International Journal of Islamic and Midle EasternFinance and Management express their views about Sukuk or Islamic bond issuance characteristics asfollows:

1. Of all the rapidly growing capital market investment instruments, none is gaining in popularity as

much as Sukuk (Islamic bonds).

2. Sukuk as investments instrument do not pay interest (non ribawi), but generate returns through

actual transactions, such as profit-sharing or leasing.

3. Sukuk commoditize the proceeds from asset transfers between capital providers and users of

different Islamic finance contracts.

4. The market for Sukuk has been growing rapidly, despite the global financial crisis triggered by

the collapse of the US subprime market.

5. Based on current trends, the total amount Sukuk is likely to exceed US$200 billion by 2010.

6. Global issuance has historically been primarily in US dollars and concentrated in parts of Asia

and countries of the Gulf Cooperation Council (GCC).

7. While Sukuk continue to evolve, a select few still dominate the market Musharaka contracts

continued to be the largest Sukuk issued in 2007.

8. The Sukuk market is dominated by corporates, which have acounted for over 86 % of total

historic issuance through 2007.

9. Many corporte issues are quasi-souvereign and as such are seen to benefit from implicit sovereign

guarantees.


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10. The thriving market of shariah-compliant securities reflects the growing need for long-term

funding instruments in Islamic finance.

11.The growth in the Sukuk market is generating interest among issuers in other regions.

12.The development of a liquid secondary Sukuk market will depend on that of a shariah-compliant

interbank market and other short-term liquidity facilities.

Historically, Sukuk or Islamic bonds issues do not exist untill after the late of 90s as we may see

from the graph below. This graph ilustrates the evolution of the Islamic Finance Industry that gives us

understanding that Sukuk are emerge as an evolution of the Islamic Finance Industry to fulfill the

Islamic capital markets need. Sukuk just exist in the late 90s; Sukuk Ijarah first issue 2001 and

souvereign Sukuk first issue in 2002 (International Financial Law Review, 2009).

Evolution of the Islamic Finance Industry &

Islamic Capital Markets

Source: Intenational Islamic Financial Market (2005)

As a new-comer in the capital markets, Sukuk have both, benefits but also constraints as investmentsinstrument (Ijlal Alvi, 2005), there are:

The key benefits of investing in Sukuk instruments:

Sukuk are priced competitively in line with conventional bond issues.

Sukuk are shariah-compliant investment.

Sukuk generally have better risk profile.

Sukuk are tradeable and fill the existing need for Shariah compatible tradeable

instruments.

Short term Islamic Financial Market can benefit from Sukuk.


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Major Constraints of investing in Sukuk instruments:

Secondary market illiquid due to absence of Critical Mass and Market Makers.

Limited awarness about these instruments in the western market and some countries

member jurisdictions.

No benchmark for portofolio monitoring as available to conventional bonds.

One of the fundamental differences between a Sukuk and a conventional bond lie in the underlyingcontract that gives rise to the financial instrument. In the Sukuk, it does not derive its experience

premised on a lending transaction whereas conventional bonds almost always do (Euromoney, 2009).

Sukuk in general may be understood as shariah compliant Bond. In its simplest form Sukukrepresents ownership of an asset or its usufruct. The claim embodied in Sukuk is not simply a claim tocash flow but an ownership claim. This also differenciates Sukuk from conventional bonds as latter

proceed over interest bearing securities, whereas Sukuk are basically investment certificates

consisting of ownership claims in a pool of assets (Shariq Nisar, 2008, Hussain Hamed Hassan).

Conclusion

Sukuk or Islamic financial bonds are relatively new instruments and only came to existenceduring the past ten years but their growth very spectacularly high . They comply with Islams

prohibition on lending on interest and the trading of debt, and are backed by physical assets.

Sukuk are equivalent to the financial bonds in the conventional world of the Islamic financialor capital market. They are tools or instruments used by financial institutions to raise cash.

The Sukuk are proof of ownership title or certificate in a particularly asset for investor. Theyare distinguished by the need for the actual existence of the asset, as well as by theircirculation potential in the capital market. Sukuk are an investment that asset backed.

The identification of suitable assets that compliant with Shariah law is the first and mostimportant step in process of issuing Sukuk certificates.

There are different types of Sukuk, such as lease Sukuk, partnership Sukuk, investmentagency Sukuk, and the like. They vary according to the companies different borrowingneeds, the nature of the asset, and the nature of the institution.

One of the fundamental differences between a Sukuk and a conventional bond lie in theunderlying contract that gives rise to the financial instrument. In the Sukuk, it does not deriveits experience premised on a lending transaction whereas conventional bonds always do.

Investing in Sukuk instrument instead it brings some of benefits it also get involves some

constraints such as illiquid secondary market, and no benchmark of portofolio yet.Reference

1. Adam, Nathif. J., and Abdulkader Thomas, (2004), Islamic Bonds: Your Guide to Issuing,

Structuring and Investing in Sukuk, Euromoney Books, United Kingdom.

2. Alvi, Ijlal, (2005), International Islamic Financial Market, KLIFF.

3. Anonymous, (2009), Sukuk: Pushing Innovation, Euromoney Institutional Investor PLC,

International Financial Law Review, London, Mar 2009.


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4. Anonymous, (2007), How to set Sukuk free, International Financial Law Review, London,

Dec 2007.

5. Anonymous, (2009), Exploring a new fund universe, The Banker, London Jun 2009.

6. Anonymous, (2009), Islamic Finance comes of age, Global Investor, London, May 2009.

7. Anonymous, Islamic Finance debate: Prospects and problems of Shariah-compliant finance,

Eoromoney, London, Dec 2008.

8. Chin, Henry, Peter Hobbs, Cameron Dowe, Richard Hedley, Tae kim, and Marcus Wignell,

(June 2008), Understanding Shariah Investment, RREEF Real Estate Research, A member of

the Deutsche Bank Group, RREEF Limited, London, http://www.rreef.com.

9. El-Gamal, Mahmoud A., (2007), Incoherence-Based Islamic Financial Jurisprodence in the

Age of Financial Engineering,

10. Fidler, Stephen, (Jun 2009), Defaults Pose Latest Snag In Islamic-Bond Market, The WallStreet Journal (Eastern Edition), New York, N.Y: Jun 16, 2009, pg.C.1.

11.Gersten, Bianca, (2007), IMF Study Determines Existence of Diversification Benefits from

Sukuk, The MEMRI Economic Blog, http://memrieconomicblog.org /bin/cntent. cgi? News

=2853.

12. Hassan, Hussein Hamed, Comments on Discussion Papers and Notes submitted for the

Harvard-LSAE Workshop on Sukuk, Dubai Islamic Bank, Dubai, U.A.E..

13.Ijtehadi, Yadullah, (Jun 2008), Gulf states raise $6.12 billion in 22 Sukuk issues,

http://www.Zawya.com. , Dubai.

14.Jobst, Andreas and Peter Kunzel. Cs., (2008), Islamic bond issuance: what sovereign debt

managers need to know, International Journal of Islamic and Midle Eastern Finance and

Management, Vol 1 No. 4, 2008, pp 330-334, Emerald Group Publishiong Limited,

http://www.emeraldinsight.com

15. Neville, Laurence, (2009), Islamic Financial Institutions Awards 2009, Global Finance,

Annual Survey, June 2009, ABI/INFORM, pg. 46.

16. Nisar, Shariq, (2008), Islamic Bonds (SUKUK): its Introduction and Application,

17.Raphaeli, Nimrod, Dr., (2008), GCC to Drive Global Sukuk Market to $200 billion by 2010,

The MEMRI Economic Blog, http://memrieconomicblog.org/bin/cntent.cgi?news=2853.

18.Raphaeli, Nimrod, Dr., (2008), Religious Scholars Impose Tougher Rules on Sale of Islamic

Bonds, The MEMRI Economic Blog, http://memrieconomicblog.org /bin/cntent. cgi? News

=2853.

19.Shohet, Maurice, (2007), Islamic Banking-Sukuk and Murabaha, The MEMRI Economic

Blog, http://memrieconomicblog.org /bin/cntent. cgi? News =2853.

20.Wilson, Rodney Professor., (2004), Overview of the Sukuk market, in Islamic Bonds: Your

Guide to Issuing, Structuring and Investing in Sukuk, Euromoney Books, United Kingdom.


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